SBRE Funds - Does Size Matter?
I read an interesting article today called “Does small equal beautiful in private equity”? In it, the author attempts to address the general tendency of investors (and humans in general) to focus on size as a measure of worth, value, and credibility. The article focuses on funds in the VC and LBO space, but I found that the concepts and the conclusions comport very closely with my observations and opinions about Small Balance Real Estate (SBRE) pooled investment funds. Let me quote a little bit of the article, which I tweeted this morning.
“Private equity thrives on asymmetries of information”, writes Olivier Dellenbach, CEO and founder of eFront, a provider of software solutions for the financial industry. “This means that as company size decreases, the amount of information available about that company also decreases, which gives an advantage to knowledgeable buyers and owners…as a result, one would expect the best-performing funds should be smaller rather than larger.” The lack of information being widely available is, in my opinion, a critical advantage to SBRE fund managers, including us, when it comes to understanding things at a granular level on smaller average deal (and fund) sizes. Because of the small size, these deals and funds do not lend themselves well to institutional capital, and thus exists the potential to generate higher risk-adjusted returns.
Let me remind the reader of my definition of “Small Balance Real Estate”. We (Fairway) define SBRE as any real estate asset backed investment strategy with an average investment size of less than $5,000,000, most often less than $2,000,000, and very often well below $1,000,000 (in some cases as little as $50,000 or even less). We further define an SBRE fund as any pooled investment fund with any real estate asset backed investment strategy whose size (actual or targeted offering) is less than $250,000,000, most often less than $100,000,000 and very often well below that figure, all the way down to starting out from literally zero. Note the highlighting of the term ANY to include not just direct ownership of real property, but any variation of investment strategy with real estate as the fundamental asset securing that investment. This would include mortgages, liens, deeds of trust, preferred equity, construction, rehab, value add, distressed/discounted note purchasing, REO, and many others.
Small funds have their disadvantages as well as advantages. Starting out at zero is very challenging for most fund managers. To paraphrase Dellenbach, there are minimum fixed costs associated with private equity (and SBRE) fund management. Their small sizes may force fund managers to charge higher fees, or asset level transaction fees in addition to fund level fees, and along these lines, there may be a minimum size below which fund performance can be eaten up by the costs and fees charged. As investors, this is something to watch out for certainly, but I have also seen well-capitalized first time fund managers deliberately delay income gratification by not charging such fees (or charging very low ones) and aligning their interests with investors in order to attract investor capital and demonstrate that they can grow their fund to a reasonable size.
His conclusion, which I happen to agree with, is that there is an optimal size, below and above which performance may decline. In SBRE, the optimal size of any given fund varies considerably, depending on the individual fund manager, the investment strategy, the asset type, the origination capacity, and many other factors. There is no “one size fits all” in SBRE. Understanding these dynamics well is critical to success in the SBRE space and can be quite difficult for most investors, particularly institutional investors, to do. This “asymmetry of information” is at the core of what enables relatively smaller funds to outperform larger funds much of the time.
One argument I hear all the time from the more institutionally minded is how much more risk there is in these small funds and how much fees are being charged. My experience is that the argument is often fundamentally specious and can even be completely self-serving on the part of the party making it. Many in this set are in fact completely ignorant of anything other than institutional sized and styled investments and have no concept of how anything could be different than that (as well as no willingness to even consider it). More importantly, while they are pointing fingers at the fees and promote structure of smaller funds, they rarely if ever are openly discussing the far heavier loads and fees that are being charged by broker-dealers, investment reps, and other “financial professionals” who do the capital raising on behalf of larger funds, which can easily run upwards of 5 – 10% or more of the invested amount.
Many investors are totally unaware of this fact because of (what I believe to be) liberal reporting requirements and methodologies that are totally legal and which allow these fees to be hidden. Big funds have a much greater ability to get away with this than small funds, for the most part. Thus, when larger fund managers and those who are raising the capital for them accuse small funds of being “fee heavy”, it is simple obfuscation at work. They are able to rely upon investors’ normal human tendency to follow their natural “bigger is better” instinct rather than a true understanding of what is happening.
A great example of this mindset in practice occurred recently at a conference attended by my colleague Darris Cassidy. He was on a panel with an institutional-minded real estate professional who simply could not fathom that anything other than an 80/20 profit split was acceptable under any circumstances. Never mind that the investors in the 80/20 fund might be (and probably are highly likely to be, if it is being sold through a broker dealer) paying a load of 10% or more of their investment the day they come into it, but due to the existing reporting laws are getting a statement showing a balance of the full investment amount (until they cash out of it) even though they have already borne that load, versus a small balance real estate fund with perhaps a lesser split, but that charges no load at all. Never mind our 80/20 promote structure might very well have multiple asset level fees of varying sizes for various activities or actions, and/or any one of several characteristics that render an 80/20 split meaningless in the context of the whole, versus some other fund that had none of those things, or perhaps fewer, and a 70/30 split or 60/40 or even 50/50.
The reporting rules that allow large investment funds (with large lobbying budgets) to effectively hide the loads being charged simultaneously enable them to encourage investors to question the fee and promote structures of smaller funds that may not look institutional on the surface. (By the way, FINRA is looking at changing the way these loads are reported and requiring complete disclosure of these fees which, not surprisingly, it is being fought tooth and nail by large hedge funds and broker dealers.) Better disclosure would be an excellent development for investors who deserve more transparency from large funds, but my belief is it will never pass because there are way too many people making way too much money willing to spend a large amount of it on lobbyists in Washington to prevent it from passing. It would be very bad for business.
I am not saying that SBRE funds are without risks. They absolutely are not, and investors need to pay close attention and do their homework. They are not, however, what financial people steeped in the institutional mindset make them out to be. Small can often be better for many reasons, as Dellenbach points out, despite claims to the contrary by people with a financial interest in doing so. One manifestation of this may very well be the way fees are charged and the amounts. Yes, 60/40 can be better than 80/20 once you dig below the surface. It may not be, but it very well may be in many circumstances. A blanket statement that “anything other than 80/20 is ridiculous” is itself a ridiculous statement. It is the very asymmetry of information in SBRE which can help improve results and, combined with the smaller average ticket size, is what keeps larger players out of the market, providing opportunity for those managers and investors who can see past the rhetoric and want to enjoy the superior returns that agility and speed can often help produce.
Matt Burk is founder and CEO of Fairway America, LLC, and SBREfunds.com, and Chief Investment Officer of Fairway’s two proprietary nationwide small balance real estate (SBRE) asset based pooled investment funds, Fairway America Fund VI, LLC, and Fairway America Fund VII LP. Fairway is the nation’s premier consulting, advisory, and investment firm in the SBRE private pooled investment fund space, providing a full spectrum of practical, real world products and services (including capital) needed for true success for SBRE entrepreneurs all over the U.S. Matt is a highly regarded adviser, consultant, and mentor to dozens of SBRE fund managers and author of a widely read blog followed by serious SBRE entrepreneurs and investors. For over 20 years, Matt has led Fairway’s deal underwriting as well as capital raising efforts in Fairway’s seven proprietary funds and individual trust deed investments, resulting in more than $250,000,000 in capital raised from accredited investors through more than 1,000 SBRE deals. He is currently working on multiple SBRE fund consulting engagements nationwide, authoring a book on how to raise capital for and effectively manage pooled investment funds, and dedicating his efforts to create greater awareness and drive more capital to the many high caliber and deserving SBRE entrepreneurs around the U.S.